1. Overview
China is one of a few tax jurisdictions that tax offshore indirect transfers (“OITs”). Under China’s Corporate Income Tax Law (“CIT Law”) and relevant regulations, an OIT refers to a transaction where (i) a non-resident enterprise (including corporations and partnerships) disposes of shares or similar rights of another non-resident enterprise who holds directly or indirectly some taxable assets (as defined below) in China, and (ii) the transaction produces an outcome that is substantively identical or similar to a direct transfer of the taxable assets. An OIT includes a reorganization that results in the change of ownership of an offshore shareholder.
Below is a typical OIT structure. The seller (a non-resident enterprise) holds taxable assets in China via one or more offshore intermediate entities. Generally, a direct sale of the taxable assets would trigger China’s corporate income tax (“CIT”). Instead, by transferring the shares of an offshore intermediate entity, the seller can “indirectly” dispose of the taxable assets and avoid triggering China’s CIT.
However, if the Chinese tax authorities determine that there is no reasonable commercial purpose to the offshore arrangement other than avoiding Chinese taxes, they may disregard the offshore intermediate entities and re-characterize (deem) the OIT (“qualified OIT”) as a direct transfer of the taxable assets. Thus, any gain from the “direct” transfer will be deemed China-sourced income and subject to CIT in China (“OIT taxation”).
For OIT taxation purposes, a “taxable asset” means: (i) an equity investment in a Chinese resident enterprise (including corporations and partnerships), (ii) real estate situated in China, or (iii) assets relating to a business establishment or premise (a domestic law concept similar to a permanent establishment) in China. A qualified OIT concerning item (i) or (ii) is taxable at a rate of 10% (i.e. standard CIT rate for non-resident enterprises), while a qualified OIT concerning item (iii) is taxable at 25% (i.e. the same CIT rate for resident enterprises).
A few key ideas to bear in mind before taking a closer look at OIT taxation in China:
- OIT taxation is an anti-abuse rule — tax authorities can collect CIT on a qualified OIT retrospectively for 10-years pursuant to the statute of limitations for CIT collection and administration purposes;
- The seller (a non-resident corporation or partnership) is the taxpayer;
- The buyer (the acquiring party who is directly obliged to pay the transfer price) is by law the withholding agent, and may prefer to report information and file the OIT tax returns;
- Current legislation on OIT taxation does not provide clear guidelines on how to calculate the taxes payable; thus, in practice, outcomes of OIT taxation can be controversial.
2. An Anti-abuse Rule
The commonly known tax regulation “Announcement 7” (State Taxation Administration’s Announcement on Several Corporate Income Tax Issues Relating to Indirect Transfers of Assets by Non-resident Enterprises, State Taxation Administration Announcement [2015] No.7) sets out the fundamental rules for OIT taxation.
Article 1 of Announcement 7 states that OIT taxation is imposed pursuant to Article 47 of the CIT Law (“Article 47”). Article 47 is the general anti-avoidance provision for CIT collection and administration purposes. It provides that where an enterprise reduces its taxable income or gain via an “arrangement with no reasonable commercial purpose,” the tax authorities can make adjustments in a reasonable manner.
Implementation Regulations for the Corporate Income Tax Law further clarifies that the term “arrangement with no reasonable commercial purpose” refers to circumstances where the main purpose of the arrangement is to reduce, avoid, or defer tax liabilities. As mentioned above, the statute of limitations applied to cases reviewed under Article 47 is 10 years. Besides the outstanding taxes, interest charges (or late-payment surcharges) could be imposed.
3. The Taxability Issue
Only qualified OITs that are determined (or deemed) as having no reasonable commercial purpose would be subject to CIT in China. Announcement 7 outlines a three-step test for the tax authorities to determine whether an OIT has a reasonable commercial purpose.
- First, determine whether any safe harbor rule is applicable; if yes, the OIT is deemed to have reasonable commercial purposes;
- Second, determine whether the defined negative list is applicable; if yes, the OIT is deemed to have NO reasonable commercial purpose;
- Third, if neither of the first two steps are satisfied, consider all the facts and circumstances regarding the OIT to determine whether any reasonable commercial purpose exists.
Step 1: Safe Harbor Rules
Announcement 7’s Articles 5 and 6 provide three safe harbor rules:
- Safe Harbor #1: OIT taxation does not apply to a non-resident enterprise’s buying and selling listed securities of the same offshore enterprise in an open market (“IPO Safe Harbor”). Offshore structures used for IPO purposes are normally considered to have reasonable commercial purposes. For example, the listed offshore entity performs functions as a fund-raising platform. In practice, the IPO Safe Harbor may be extensively applied to situations where the listed securities were acquired pre-IPO, or where the OITs take place off-market. Alternatively, arguments that the OITs have similar reasonable commercial purposes can be raised in Step 3.
- Safe Harbor #2: OIT taxation does not apply to a non-resident enterprise who would be exempted from CIT liabilities in a direct (holding and) transfer of the taxable assets under applicable tax treaties or other tax arrangements (“Treaty Safe Harbor”). In principle, OIT taxation does not supersede the application of tax treaties. Also, if a direct transfer is non-taxable, then the offshore holding and transfer arrangements would not be primarily tax-driven. Thus, the OIT structure is deemed to have a reasonable commercial purpose.
- Safe Harbor #3: An OIT that meets all of the below requirements is deemed to have reasonable commercial purposes (“Reorganization Safe Harbor”).
(1) The buyer and seller are related through ownership, that
(i) the seller directly or indirectly owns 80% or more shares of the buyer;
(ii) the buyer directly or indirectly owns 80% or more shares of the seller; or
(iii) the seller and the buyer are both owned, directly or indirectly with an 80% or more stake respectively, by the same third-party;
provided that if more than 50% of the offshore target’s equity value is directly or indirectly derived from immovable property located in China, the above items (i) to (iii) shall be applied by substituting “80% or more” with “100%”;
(2) The OIT (being examined) will not result in any tax reduction or avoidance outcome for a subsequent OIT that may occur, compared to an identical or similar OIT that could take place without the first-mentioned OIT (being examined); and
(3) The buyer pays the transfer price solely with its own shares or shares of its affiliates (not including stocks of listed companies).
Reviewing requirements (1) and (3) together, the main idea is to retain the equity interests of the offshore target (and its subsidiaries and underlying assets) within the same affiliated group (i.e. continuity of interest). As shown in the below simplified charts, the ultimate ownership (at least 80%) of the taxable assets being transferred remains the same.
In real cases, the ownership structures can be much more complicated (and the equity consideration paid by the buyer would increase the complexity of the post-transaction structures). An OIT may not firmly satisfy requirements (1) and/or (3). But, as we observed, if the OIT was carried out with a reorganization background (especially if the seller could maintain a continuing interest in the buyer), the Reorganization Safe Harbor might be extensively applied. Alternatively, arguments regarding whether a reasonable commercial purpose applies can be raised in Step 3.
Notably, requirement (2) is an anti-abuse rule. Without requirement (2), for example, the seller (who is not eligible for the Treaty Safe Harbor) could transfer shares of the offshore target to an affiliate (who will be eligible for the Treaty Safe Harbor in a subsequent OIT) and invoke application of the Reorganization Safe Harbor. Thus, the two OITs could both be tax-free in China. But with application of requirement (2), the first OIT will not satisfy the Reorganization Safe Harbor.
Step 2: Negative List
Article 4 of Announcement 7 lists four negative factors (“Negative List”), the complete satisfaction of which would conclude that the OIT of concern has NO reasonable commercial purpose. If the Negative List applies, then there is no need to further examine other facts and circumstances regarding the OIT through Step 3.
The four negative factors include:
(1) 75% or more of the value of the offshore target is directly or indirectly derived from taxable assets in China;
(2) At any time during the one year period preceding the OIT, 90% or more of the assets of the offshore target (excluding cash) directly or indirectly consists of equity investments in China, or 90% or more of the revenue of the offshore target is directly or indirectly derived from China;
(3) although the offshore target and its subsidiaries that directly or indirectly hold the taxable assets in China were formally incorporated and are in lawful existence in other jurisdictions, they factually perform functions and bear risks to a limited extent that are insufficient for purposes of proving economic substance; and
(4) the amount of taxes paid in other jurisdictions related to the OIT is lower than the possible Chinese tax liabilities that would arise in a direct transfer of the taxable assets.
The Negative List is an example of the reasonable commercial purpose test being applied. However, Announcement 7 does not provide detailed guidelines on how to evaluate, assess, or determine each factor (discussed further below).
Step 3: Reasonable Commercial Purpose Test
Lastly, if neither the safe harbor rules nor the Negative List is applicable to an OIT, it must be evaluated under the reasonable commercial purpose test pursuant to Article 3 of Announcement 7.
The test is fact determinative and requires consideration of eight factors (with one factor being a “catch-all”). Moreover, all facts related to the OIT are reviewed as a whole.
The eight factors include:
(1) whether the main value of the offshore target is directly or indirectly derived from taxable assets in China;
(2) whether the majority of the assets of the offshore target directly or indirectly consists of equity investments in China, or the majority of the revenue of the offshore target is directly or indirectly derived from China;
(3) whether the offshore target and its subsidiaries that directly or indirectly hold the taxable assets in China perform functions and bear risks that are sufficient to prove the economic substance of the enterprise structures;
(4) the period of time that the offshore target’s shareholder(s), business models and organization structures exist;
(5) the amount of taxes paid in other jurisdictions related to the OIT;
(6) feasibility to substitute the “indirect” holding and transfer arrangements with “direct” holding and transfer arrangements by the seller;
(7) application of tax treaties or other tax arrangements to the taxable gains of the OIT in China; and
(8) other relevant factors.
The reasonable commercial purpose test, in our opinion, examines three aspects of OITs, namely,
- sources of the (consolidated) value, assets and revenue of the offshore target;
- economic substance of the offshore structures; and
- evidence of tax-driven motives.
However, Announcement 7 (or other relevant tax laws or regulations) do not provide clear guidelines on how to evaluate, assess, or determine the eight factors. For example, there is no definition provided for many of the terms. The words “main” could mean “more than 50%” or “at least 75%” (i.e. the standard used under the Negative List). Also, in determining the “value” of the offshore target, it is not clear if it refers to the book value, fair market value, appraised value, or other indicators. Thus, Announcement 7 itself is ambiguous, and leaves decision making authority to the tax authorities’ discretion.
Generally speaking, if the offshore structures were in existence for a considerable period of time with substantive business operations outside of China (not in close connection with affiliates in China), the OIT will likely be considered to have a reasonable commercial purpose. This is true when the offshore entities have positive retained earnings, and when the offshore entities have negative retained earnings from business operations outside of China. However, if the offshore entities have significant losses from business operations outside of China, the tax authorities may decide that the value, assets, and revenue of the offshore target mainly (even more than 100%) comes from China.
In practice, the tax authorities’ interpretation and application of the rules vary. In actuality, the tax authorities may not strictly follow the three-step test. The taxability issue (whether OIT taxation is triggered) and the tax computation issue (how to calculate the amount of taxes payable) are sometimes assessed together. Notably, parties to OITs may also have split opinions and take opposite positions on OIT taxation.
4. The Tax Computation Issue
Above all, Announcement 7 does not expressly address the tax computation issue, i.e. how to calculate the amount of taxes payable.
From a practical perspective, one opinion is to treat OITs the same way as “direct” transfers of the taxable assets. It is in line with the “pass-through” idea of OIT taxation (i.e. to disregard all intermediate shareholdings).
In a direct transfer of a Chinese company’s shares, the taxable gain is the excess of the income realized by the seller (including any and all forms of consideration received) over the tax basis of the seller (including any acquisition costs and capital contributions previously made, and subject to proper adjustments) with regard to the shares being transferred.
However, in an OIT structure, there is likely no directly available information regarding the seller’s income realized or tax basis regarding the shares of a Chinese company being “indirectly” transferred. On the income side, the parties may negotiate and agree on a transfer price based on the consolidated valuation of the companies involved in the deal. The Chinese company is not normally valued on a standalone basis. On the tax basis (cost) side, any acquisition price or capital contribution previously made for the shares of the Chinese company was likely paid by or on behalf of the direct owner(s) of the shares. Of course, the seller may actually be the one to bear the costs and also the burden of proving the actual costs.
Thus, in practice, the tax computation issue has caused numerous controversies and disputes. Based on our observation, the tax authorities commonly rely on the consolidated valuation of the companies as a whole, and make necessary adjustments to ascertain the taxable income attributed to the Chinese company. For example, to subtract the total net asset value of the offshore entities from the total transfer price. Theoretically, if the total net asset value of the offshore entities is negative it could generate a higher number than the agreed transfer price.
Meanwhile, the seller’s tax basis in the Chinese company is usually calculated by multiplying the Chinese company’s paid-in capital (including additional paid-in capital) by the seller’s percentage of (direct and indirect) ownership in the Chinese company.
The above tax basis calculation induces at least two adverse effects for the seller. First, any capital contribution made by the seller to the offshore target that was not reflected in the Chinese company’s paid-in capital is disregarded. Second, the seller’s actual costs in the Chinese company is diluted by other shareholders (especially the founder) whose costs in the Chinese company are much lower. To avoid these effects, the seller can submit evidence on its actual costs in the Chinese company to the tax authorities and propose appropriate adjustments to the above calculation.
Moreover, an additional allocation issue arises when an OIT structure involves several (and maybe different types of) taxable assets in China. Allocation of the taxable gain among the taxable assets is required because the tax authorities in charge of the taxable assets and the respective tax revenues could be different.
Again, current legislation on OIT taxation does not provide clear guidelines on how to solve the allocation issue. Currently, there is one precedent issued by the Supreme People’s Court (the highest trial organ in China) that discussed and ruled on this issue. But remember that China is a civil law jurisdiction, and judicial decisions are neither binding nor persuasive authority.
5. Tax Filings and Information Reporting
In light of the taxability and tax computation issues discussed above, how can the parties secure tax certainty and manage risks related to OIT taxation?
First, it is important to remember that the buyer is by law the withholding agent. The buyer’s withholding obligation cannot be assigned or delegated via contractual agreements.
As a tax incentive for the buyer to report the OIT information, Announcement 7 provides that the buyer may be relieved partially or fully from the liabilities for failure to withhold taxes if the buyer can timely (within 30 days after the share purchase agreement or other similar legal document is executed) report relevant OIT information to the competent tax authorities in China.
Besides the above information reporting, the buyer should also make sure that any taxes payable are paid in full. Thus, the buyer’s tax basis in the shares of the offshore target (and theoretically in the underlying taxable assets of concern) can be recognized in a later OIT (or arguably in a subsequent “direct” transfer of the underlying taxable assets).
Second, the seller is the taxpayer and bears the actual tax burden unless otherwise agreed. Considering the above-mentioned uncertainty related to the taxability and tax computation issues, the seller should handle OIT taxation in its best interest, and may take opposite positions as to tax filings or information reporting. For example, the seller may take a view that the transaction of concern is not a qualified OIT (i.e. OIT taxation is not triggered) and refuse to file tax returns or information reporting, while the buyer may want to release its potential liabilities for failure to withhold taxes and insist on filing tax returns or information reporting.
It is commonly seen in practice that the seller offers or promises to take care of OIT taxation personally, and, if applicable, to file tax returns on the OIT via self-declaration (rather than via withholding declaration by the buyer). In this case, it is important to include tax liability provisions in the transaction documents. However, it should be noted that the contractual agreements cannot change each party’s statutory obligations.
Lastly, the Chinese company being “indirectly” transferred should also guarantee that the OIT complies with the above-mentioned regulations. The tax authorities may contact the Chinese company before any other party if the tax authorities have any questions regarding the OIT. The Chinese company is legally obligated to provide information to the tax authorities upon request.
In practice, parties to OITs have been increasingly cognizant of the potential risks of OIT taxation. For example, comprehensive tax analysis on the application of OIT taxation (the taxability issue) is often prepared by the parties during negotiations. Further, tax liability provisions on OIT taxation are incorporated in the transactional agreements, including agreements regarding information reporting, filing of tax returns, and other procedural matters.
6. Key Takeaways
OIT taxation in China is imposed pursuant to Article 47 of the CIT Law, i.e. the general anti-avoidance provision for CIT purposes. In case an OIT is found to have no reasonable commercial purpose other than avoiding Chinese taxes, the Chinese tax authorities can disregard the offshore intermediate entities and re-characterize (deem) the OIT as a “direct” transfer of the taxable assets. Article 47 has a 10-year statute of limitations.
Announcement 7 sets forth the fundamental rules of OIT taxation. It provides a three-step test for determining whether an OIT has a reasonable commercial purpose, and consequently whether the OIT gives rise to CIT liabilities in China. However, due to the ambiguity of the rules, application of OIT taxation is often controversial in practice.
Thus, parties to OITs should focus on the potential risks of OIT taxation and take necessary steps to secure or enhance tax certainty. These steps include, but are not limited to:
(1) preparing comprehensive tax analysis on the application of OIT taxation, for purposes of internal decision-making and documentation, and as needed, supporting negotiations with the counterparty and discussions with tax authorities; in particular, the seller would often need detailed and comparative analysis on the tax computation issue to better assess its potential tax burdens, develop strategic plans, and take actions;
(2) incorporating tax liability provisions on OIT taxation in the transactional documents; the tax liability provisions should clarify each party’s (i) obligations regarding tax filings and information reporting, (ii) liabilities for any costs or burdens incurred due to OIT taxation, and the mechanisms for compensation, reimbursements, indemnification, and (iii) other procedural and contractual matters; note that the buyer’s statutory withholding obligation cannot be assigned or delegated via those provisions;
(3) assessing the transactional documents terms, related accounting matters, and other matters of significance concerning the OIT as a whole, and retaining necessary documents to later justify arguments regarding the OIT structures’ reasonable commercial purposes; and
(4) filing of tax returns or reporting applicable information to the competent tax authorities to obtain their approval or consent; further, parties to the OITs should be prepared to discuss with the tax authorities issues regarding taxability, tax computation, and other matters.
Additionally, it is worth mentioning that Announcement 7 only addresses OIT taxation on non-resident enterprises (corporations or partnerships). Recent tax developments on individual income taxation provide a domestic law basis for the tax authorities to impose taxes on non-resident individuals who dispose of taxable assets (especially immovable assets) in China through offshore indirect holdings and transfer structures. Therefore, non-resident individual sellers should also be vigilant of the risks related to OIT taxation.
In sum, we highly recommend parties to cross-border investments, M&As, and reorganizations carefully assess their potential liabilities and risks related to OIT taxation in China.
For more information, please contact our tax professionals listed below:
Special thanks to Andrew Sklar for his contributions to this article.
